Optimal Debt and Equilibrium Exchange Rates in a Stochastic Environment: An Overview

Abstract:     
The focus is upon equilibrium real exchange rates, optimal external debt and their interaction, in a world where both the return on investment and the real rate of interest are stochastic variables. These theoretically based measures are applied empirically to answer the following questions: What is a theoretically based empirical measure of an excess debt that increases the probability of a debt crisis? What is a theoretically based empirical measure of a misaligned exchange rate that increases the probability of a currency/balance of payments crises? Two theoretical tools are used to derive Early Warning Signals. One is the NATREX model to estimate the equilibrium real exchange rate. The second is stochastic optimal control/dynamic programming to derive the optimal debt and endogenous growth rate. Examples are given of these applications.

Number of Pages in PDF File: 59

Keywords: stochastic optimal control, foreign debt, NATREX, vulnerability to external shocks, sustainable current account, warning signals of debt crisis, exchange rate misalignments

JEL Classification: C61, D9, D81, F3, F4, F31, F34

working papers series